Determinants of Consumption Spending

The average American Household spends about 68 percent of his income on consumer goods—the remainder goes to taxes and savings.

Why 68 percent? To answer this question we must discuss how people make choices about consumption, borrowing, and saving.

A key point is that decisions regarding current consumption are influenced by not just current conditions but also expectations about the future. Borrowing allows you to increase current consumption in exchange for future sacrifice.

· The amount of future sacrifice depends partly on how much income you expect to have in the future. With more future income the future sacrifice is less.

· It also depends, in part, on the current interest rate, since lower interest rates reduce the opportunity cost of borrowing as well as the rate of return on lending. (Could lower interest rates cause less consumption—Japan?)

· Taxes are an exogenous factor that can influence this decision. Are tax changes temporary or permanent? Is the rate expected to fall or rise in the future?

Controversial Issues:

· Do Americans over borrow (under save)? This is a normative question that is difficult to explain since it depends upon a person’s choice between the present and the future. We can predict the influences of variables that tend to affect borrowing for current consumption, but we cannot determine if the choice is optimal.

· Are falling interest rates desirable? Borrowers benefit at the expense of lenders. Is the lower income earned by lenders a “secondary impact” that is less important than the “primary impact” on consumer spending? In terms of aggregate demand, lower interest rates are likely to increase current consumption but to lower the income of savers for future consumption.

· Why is the aggregate demand for consumer goods not influenced as much by the substitution effect of a price change as the consumption of an individual good? (The international effect only) Why would a lower price level that increased real income of consumers not increase consumption? (Less income received by producers lowers consumer income.)

· How does a price change influence consumer spending? The wealth effect on current consumption, the real interest rate effect on current consumption versus borrowing, the international trade effect on net exports (relative prices and real exchange rates) These effects may also influence investment spending by business firms.